7. Exchange Rates

Question 1

Whats the nominal exchange rate?

When the nominal exchange rate rises, we say that…

Answer 1

• price of one (domestic) countrys currency in units of another (foreign) countrys currency
• Units of foreign currency / 1 unit of domestic currency

… the domestic currency is appreciating (gaining value). When the nominal exchange rate falls, the domestic currency depreciates

Question 2

Fixed Exchange Rate Regime | Whats one way to fix the exchange rate below its market value? Why should we aim for an exchange rate above market value?

1.
2.
3.
4.

Answer 2

• government can increase countrys net exports (because they are cheaper for foreign countries)
• in general: government must be prepared to sell its own currency (to keep it undervalued) or to buy it (to keep it overvalued)
• reason 1: staying able to pay for foreign debt
• reason 2: keeping the price for imports low

Question 3

What are the different exchange rate regimes a country can adopt?

1.
2.
3.

Answer 3

• flexible (or floating) exchange rate: governemt does not intervene in foreign exchange market
• fixed (or pegged) exchange rate: governemnt foxes a value and intervenes to maintain that value
• managed exchange rate: a system between flexible and fixed exchange rates

Question 4

Whats the real exchange rate?

1.
2.

Answer 4

• takes into account the price level in the two countries
• its the ratio of the dollar price of a basket of goods and services in the US divided by the dollar price of the same basket of goods and services in a foreign country

Question 5

If the real exchange rate is high…..

Answer 5

…. foreign goods are relatively cheap and domestic goods relatively expensive

Question 6

How do the real and nominal exchange rate move?

Answer 6

• move togewther, but not perfectly since the real one also takes price levels in the countries into account (nominal little higher than real one)

Question 7

Yuan and the Dollar

If the real exchange rate E (in yuan per dollar) goes up (Dollar appreciated and Yuan depreciated)

Answer 7

• US will import less to china and import more from china (or: china will import less from US and export more to US)
• i.e. US net exports will decline

Question 8

Yuan and the Dollar

If the real exchange rate E (in yuan per dollar) goes down (Dollar depreciates and Yuan appreciates)

Answer 8

• US will export more to china and import less (or: china will import more from US and export less to US)
• US net exports will increase

Question 9

Why did China for a long time leave the Yuan undervalued?

1.
2.
3.

Answer 9

• to boost exports to other countries
• undervalued Yuan= high real Yuan-per-Dollar exchange rate
• but, this hurts the chinese people by shrinking their buying power and industries in other countries

Question 10

What are some economic consequences in the US (!) of keeping the Yuan undervalued?

1.
2.
3.

Answer 10

• E goes up; then the foreign net exports go down
• decreasing foreign net exports shrink the foreign GDP
• can cause employment abroad to fall (downwards wage rigidity)

Question 11

What did the Swiss Bank do when people put a lot of their money there during the financial crisis?
What happened in the following Euro crisis?
What did the bank do as a solution?

1.
2.
3.

Why is it still risky to go on like this forever?
1.
2.

Answer 11

• sold Swiss francs for foreign reserves to keep the swiss franc from appreciating too strongly
• in Euro crisis: situation became even more extreme and switzerland began to suffer from unemployment (bc of cheap import and expensive export prices)
• bank took action and chose to not allow exchnage rate to drop below 1.2 swiss francs/euro -> foreign reserves rose drastically

1. floowing the market with LOTS of swiss francs risks inflation
2. having more and more foreign (euro) reserves may not be a safe investment from the swiss banks viewpoint

Question 12

Why did the Swiss bank give up the exchange rate floor?

Answer 12

• ECB was starting QE (expected to lead to further depreciation of the Euro)
• still keeping the flooer here would mean taking in even more euros and running an even larger risk of huge capital losses

Question 13

A decline in net export reduces….

Answer 13

…. labor demand and GDP and might cause unemployemnt

Question 14

Under a managed or fixed exchange rate regime, the government wants to…

Answer 14

…. intervene

Question 15

Fixed or Managed Exchange Rate regime | Whats one way to fix the exchange rate if its below target?

What must a government be prepared for to do this?

Answer 15

• increasing a countrys net exports (because they are cheaper for foreign countries right now)
• be prepared to sell own currency (to keep undervalued) or to buy it (to keep overvalued)

Question 16

What are reasons to fix the exchange rate above its market value?

1.
2.

Answer 16

• staying able to pay for foreign debt
• keeping the prices for imports low

Question 17

Pegged exchange rates | Yuan per Dollar
1. If the fixed rate is above e* (market equilibrium), you have to pay….. As a consequence….
2. If the fixed rate is below e*….

Answer 17

1. more yuan per dollar than under e* (Supply > Demand). …. it takes more yuan to buy 1 USD, thus making chinese exports cheaper to foreigners
2. less yuan per dollar than under e* (Demand > Supply)

Question 18

Scenario: we have the natural equilibrium e*, and the pegged fixed rate e

1. if we set the pegged rate e above e*, what happends to demand and supply?
2. if we set the pegged rate e above e*, what happends to demand and supply?

Answer 18

1. supply > demand: there is greater supply of the foreign currency than there is demand (if we say yuan per dollar, then USD). foreigners offer more dollars in exchange for home currency (yuan), then there is home demand for the foreign currency
2. demand > supply: there is greater demand from home people to buy the foreign currency (eg purchasing foreign goods) than we have supplied at this rate. eg the government here sells a lot of the foreign currency and buys a lot of home currency, increasing supply of foreign currency and keeping value of home currency high

Question 19

1. To keep a country´s value from appreciating to much, a country will….
2. To keep a country´s value from depreciating, a country will…

Answer 19

1. Purchase foreign currency and sell home currency. (undervaluing home currency)
2. sell foreign currency and purchase home currency, to increase supply of foreign currency (overvaluing home currency)

Question 20

Geroge Soros | He borrowed british pounds and sold them for the deutsche mark, because why?

Answer 20

• he assumed the pound will depreciate
• when this happened, the german marks were now much more worth in terms of pounds
• he repaid his pound debt at the lower exchange rate (buying pounds back at cheaper rate) and then had 1 billion profit

Question 21

If the real exchange rate is high, foreign goods are…. and domestic goods are…

Answer 21

…. relatively cheap and domestic goods relatively expensive (and vice versa)

Question 22

Real Exchange Rate in Yuan/ Dollar

If the dollar appreciates or the Yuan depreciates, e….

What will be the consequence?

Answer 22

…. goes up

US will export less to china and import more from china / china will import less and export more to US

-> US net exports decline

Question 23

Yuan / Dollar

If the real exchange rate goes down, US net exports……

Answer 23

….. will increase

( dollar depreciates or yuan appreciates)